Life on the Phillips curve

Mainstream macro in the 1970s (which a lot of people seem to have gone back to) held that there was a NAIRU, meaning the non-accelerating inflation rate of unemployment. If unemployment was above that, inflation would fall. If it was below that, inflation would increase. So, policy should shoot for the NAIRU.

These days, unemployment is 8.3 percent, and inflation is increasing. Just sayin'.

Just sayin'...what, exactly? Don't imply, man, argue! Follow the point through to its conclusion and see if it actually holds together! Since Mr Kling didn't, I'll do it for him.

The NAIRU, as Mr Kling notes, is the non-accelerating inflation rate of unemployment. It corresponds to maximum structural employment; the economy can't sustain a higher level of employment than this without structural reform of some kind. Why is it called the non-accelerating inflation rate? Well, were the government to try to raise employment above that level, fiscally or monetarily, inflation would accelerate. Stimulus would raise demand for goods and services, which would lead to higher prices. Individual firms might respond to higher prices with increased production, by using higher wages to attract employees from other firms, but since there is no surplus labour at the economy-wide level, overall production can't undergo a sustainble increase in output. Instead, price increases trigger higher wage demands (which firms must accommodate given the lack of surplus labour), and higher wages trigger price increases. Expectations begin to adjust to take into account this dynamic; firms build in larger price increases to take into account probable future wage rises, and workers build in larger wage demands to take into account probable future price increases. Inflation accelerates, and to prevent economic disaster the government must tighten policy to reduce labour and product demand back to the economy's potential and re-establish inflation expectations at a steady level.

Got that? Now, Mr Kling says that according to this theory a rate of unemployment below NAIRU will trigger an increase in inflation. He then observes that with 8.3% unemployment, inflation is increasing. And he deploys the just sayin' line to imply that the economy is therefore below NAIRU—that is, at structural full employment, suggesting that further demand stimulus is undesirable. He is wrong on multiple levels.

First, it's very difficult to discern a steady increase, to say nothing of acceleration, in the inflation figures. Mr Kling points to a Calculated Risk post which discusses the Cleveland Fed's latest inflation analysis. That analysis notes that core consumer prices rose 0.2% in January. In 4 of the last 6 months, core consumer prices rose by 0.2%. Median CPI rose 0.2% in January. That is the same rate of increase observed in December, November, October, and September. In August, median CPI rose 0.3%. Inflation is positive and has risen on some measures. On others, however, it has declined. Perhaps most importantly, it is difficult to impossible to discern accelerating growth in wages, which is the most relevant price in this dynamic. Indeed, wages seem to be rising more slowly than prices generally. That translates into a relative reduction in real wages which is likely to encourage firms to draw more of the existing stock of surplus labour into employment.

But let's take a step back. A mainstream saltwater economist, of the sort Mr Kling would seem to distrust, would probably characterise the present economy in the following way. Slow growth and high unemployment indicate a problem, the most likely solution to which is looser monetary policy. In particular, it seems probable that the market-clearing real interest rate is below the actual interest rate, and if the central bank were to reduce its interest rate then full employment would soon be restored. Since the central bank's interest rate is close to zero, however, we have to assume that the market-clearing real interest rate is negative. To reduce the central bank's real policy rate further would require an increase in inflation. And from this we can generate a simple, testable prediction: if the central bank succeeds in raising inflation expectations, then it will move the policy rate closer to the market-clearing real interest rate, and unemployment should fall.

How does the real world match up against this simple model? Well, in August, short-term inflation expectations (as measured by 2-year breakevens) dropped below 1%. The real interest rate, as computed by the Cleveland Fed, sat above -1%. And the unemployment rate was 9.1%. In August, the Fed introduced language suggesting that short-term rates would be at exceptionally low levels through 2013. Inflation expectations began rising and were comfortably above 1.5% by early 2012. The real interest rate dropped, falling to -1.75% by December of last year. And unemployment has since fallen by nearly a percentage point.

Based on this, it seems reasonable to conclude that the Fed raised expectations which therefore encouraged more hiring. And it appears, based on the absence of accelerating inflation—and especially wage inflation—that this hiring has merely drawn workers out of a substantial pool of surplus labour. Mr Kling appears to have gotten both the diagnosis and the direction of causation wrong. And before we begin asking the central bank to engineer a rise in surplus labour, I'd hope to see substantially more proof that America is reaching the structural limits to increased employment.

One other point: Mr Kling updates his post with a quote from another blogger:

...if the economy is operating significantly below potential, inflation should have negative acceleration into a deflationary environment. However the two measures have diverged recently, indicating that the slack in the economy may not be that great.

It has been clear for some time that this is not the way modern economies work; we don't observe accelerating deflation. There is a very useful literature on persistent, large output gaps that describes the actual dynamics. Here, for instance, is an IMF paper on the subject:

This paper studies inflation dynamics during 25 historical episodes in advanced economies where output remained well below potential for an extended period. We find that such episodes generally brought about significant disinflation, underpinned by weak labor markets, slowing wage growth, and, in many cases, falling oil prices. Indeed, inflation declined by about the same fraction of the initial inflation rate across episodes. That said, disinflation has tended to taper off at very low positive inflation rates, arguably reflecting downward nominal rigidities and well-anchored inflation expectations. Temporary inflation increases during episodes were, in turn, systematically related to currency depreciation or higher oil prices. Overall, the historical patterns suggest little upside inflation risk in advanced economies facing the prospect of persistent large output gaps.

The data match up very, very well with a story of a large and persistent American output gap. I don't really know why folks are so anxious to see something else in the numbers.

Fifthly, consumer-goods are different from each other. The long-term market interest rate is hard for the central bank to control when it has fallen to a level which is considered unsafe by representative opinion. It is because the lack of confidence about the future is identical with the lack of confidence about a sufficient improvement of the schedule of the marginal efficiency of capital or of the portfolio of investment, by which productive investment should replace unproductive investment to a sufficient extent within the corresponding time frame by the end of which the present monetary policy, i.e. monetary easing, will have come to change, i.e. an exit strategy. The CPI can reach the presently (and loosely) targeted 2% within the same time frame even if productive investment hasn’t changed unproductive investment: The set of consumer-goods supplied within the economy can be one of which some consumer-goods are insufficiently supplied to increase the CPI to the loosely targeted level even if other consumer-goods have become dead stocks. (The present-day US economy, depending much on imported consumer-goods for its internal consumer-goods supply, must be a typical case. That must explain the reason why deflation has not been observable. Hence, the same is said of developing economies, where its internal supply of consumer-goods largely depends on imports.) When markets see it through, the confidence is insufficient to raise the long-term interest rate to a level which is considered safe by representative opinion. The central bank can do little or nothing on it. New Liberals and Ordoliberals say it’s markets’ job because both follow Say’s law, and say the government can’t improve the portfolio of the aggregate or current investment. I find it their idea quite odd. Improving the schedule of the marginal efficiency of capital is not the job of the central bank but should be the one of the government.

Sixthly, for the same reason as presented in the previous paragraph, it is unwise of the government to just attempt to increase the aggregate investment straightforward. New Keynesians, as part of New Liberals, tend to insist on increasing the aggregate investment by the fiscal policy to directly fill the supply-demand gap. That is flawed.

Lastly, it is a matter of course a few years of very large war, perhaps against economies that haven’t nuclear warheads but have a considerably large collective military power (e.g. Central and South America and the Islamic world), is an easy solution to the present, unfavourable set of investment. In that case, the US economy may be able to redirect its present set of investment to the wartime set, by which dead stocks disappear by the end of the war. The Iraqi war failed in this regard because the war was too small to redirect the entire set of investment in the US, which amounts to trillions of dollars. (The Japan earthquake filed in this regard because the earthquake and tsunami were too small to redirect the entire set of aggregate investment in Japan, which also amounts to trillions of dollars.) This solution is theoretically effective as a matter of course. Still, it is a mad solution. Don’t start a war, Americans! If a scale is too small, it is not only morally wrong but also wasteful as economic policy. If large enough, it is more morally wrong while it will revive the golden 50’s in an instant.

"inflation is increasing"? Er ... I'm not sure that the current rate going from almost non-existent to a negligible amount is what they were talking about back in the 1970s when double digit inflation was the threat and sometimes the reality.

Ok then. Either the working class take over the running of the world economy, through the socialist revolution, or world capitalism, in it's death agony, will launch a final catastrophic war which will take the survivors back to the primitive savage state.

Remember back then?
College kids, Women and minorities couldn't get credit.
One had to have a good down payment and a job to buy a house or car.
Auto loans averaged 4 years.
A larger share of Americans belonged to unions, and the unions could demand higher wages for work.

We don't need no stinkin' wage hikes, we can borrow and spend.
That's the policy the Fed's wants us to engage in.

Real average hourly earnings fell 1.0 percent, seasonally adjusted, from January 2011 to January 2012. A 0.6 percent increase in the average workweek, combined with the decline in real average hourly earnings, resulted in a 0.4 percent decrease in real average weekly earnings during the same period.

Would be nice to try to solve our present problems of unemployment.
What about producing products that Americans want in America?
Would these products be too expensive, or would this system provide less monies for the middle man?
heated

We have seen the biggest redistribution of wealth in world history recently, from the workers, elderly, sick, the poor, the toilers and the exploited, to the bourgeoisie, the bosses, and the bankocracy- to the tune of tens of trillions of dollars. Slavery has returned to britain, where the government are handing out thousands of pounds to the bosses just to take on workers, who then work for nothing. The capitalists have enjoyed zero interest rates for an unprecedented period, yet the representatives of British capital are calling for a further reduction in business rates, and, incredibly, a further attack on trade-union rights(!)
The great soup kitchens of the world, formerly called nation states, are being prepared for a return to the middle ages... the various economic models of the capitalist system have proven worthless and bankrupt. The all-out economic and class war being launched by world capital, will end eventually, with the working class coming to power through the socialist revolution and no force on Earth shall stop it!
Workers of the world unite!

It's hard to make these arguments when inflation is so poorly measured. The impact of product improvement and innovation is left out of these stats. To understand the problem, ask what are quality and convenience? Imagine one equation that ties these ideas together and gives a scale for utility. I know that sounds like an extraordinary claim, but this video will convince you. http://www.youtube.com/watch?v=2c4mvGekYZY

By the way, as someone who tries to buy stuff within my household budget, it sure seems to me that inflation is running more than 1%. Yeah, I know, official statistics don't show it. The real world *does* show it, however, and I believe the real world more than I believe the official statistics.

Well then, UTILISE 100% OF ECONOMIC CAPACITY, cut the working week by half, utilising the entire labor force... only problem we have here is that Bill Gates et al would not be expropriating the billions of dollars from the workforce... and as far as your "expand" the present world economy, a cursory glance would tell you that TRADE BARRIERS/WARS are the next step for western capital, and a further deceleration in Chinese growth and a rise in the class struggle there will transform the world situation.
Overproduction, overcapacity, is the lot for world capitalism, until the working class realise their historical destiny and rise up in revolt against their exploiters.
Workers unite!

How can any theory about these changes be correct unless it takes into account all of the variables? None of the above ideas include the effect of the good productive rural and urban land being held out of use. Then the associated raised rents and costs, due to the fierce competition for its access have the effect of reducing demand for the produced goods.
To increase this opportunity to use all of the suitable land properly, its price must be lowered and its being withheld stopped. This will reduce its high cost and with cheeper goods demand will rise along with greater employment. It is not a matter of manipulation of the money, without more demand nobody needs to make goods.
The Phillips theory does not allow for this which is why needs several curves to cover the time till now. And to reduce land monopoly and free the opportunities for its access one needs to tax land values instead of incomes. Simple theory works best.

Could be not be saying that he doesn't have much truck with NAIRU or the present economic consensus because inflation is still increasing while unemployment remains so high, that instead something else is going on?

"Expand" referred to monetary policy (alluded to by juxtaposition to "stimulate/invest" in reference to fiscal policy).

Other than that, I can't make any sense of your rant. Take a deep breath, exhale, repeat. Then try to have your words and sentences connect in some logical fashion. Do not capitalize entire words - it reads like shouting.

For the last 3 years USA experimented economic growth recovery without jobs, some economists even look back to 2006 for this effect. It appears that economic conditions leading to employment are changing and we haven't meet them yet. Perhaps we need to define an IRRU (Inflation Rate Reducing Unemployment) way higher than the 2% target? In another hand it seems that high growth rates are behind us (USA, Japan, Europe at least) so in the case, high inflation (well high should be 4%) may be like given 5 liters of coffee to someone exhausted, you give him strain but no strength. I think and top economists think too (O Blanchard, P Krugman) that we need to redefine a knew analysis framework for macroeconomic, especially given the big impact of international openness of world economies. The fact that we look in 70's theory to explain what's happen now is a clue that in fact we aren't understanding well situation (to be clear I have nothing again 70's macro theories but it seems to me that most serious peoples haven't forgot them and yet they can't really explain the present situation.http://www.side-effects.fr